Will Teaser Loans give a shock to Customers in 2013?

The RBI has recently expressed its concern about the teaser loans, stating,

“In the area of housing loans, teaser rates are increasingly being offered which is a cause for concern. I hope banks are ensuring that borrowers are well aware of the implications of such rates and the appraisal takes into account repaying capacity of the borrowers when the rates become normal.”

The point being made was that when the ‘teaser rate period is over (2-3 years in most cases) and interest rates shift to the normal floating rates prevalent at that time the consumers may not be able to cope up with the resultant increases in EMIs (especially if, as widely expected, interest rates go up significantly in the meanwhile).

I give a small calculation here for the better understanding of ‘teaser rigmarole. Take the case of a typical 30-year-old salaried person with a net salary of around Rs. 40,000. As per the eligibility calculations he would be able to get a loan of Rs. 20,00,000 from State Bank of India (SBI). (See box for eligibility calculation)

How do ‘teaser rates work?

SBI who pioneered these loans prefers to call them Low cost loans rather than ‘teaser rate loans. Whatever be the label, in the Indian context, it has meant loans in which the interest rates are fixed for the first 2-3 years (5 years also in a couple of cases) and which reverts to regular floating rates after the initial fixed interest rate period is over. For example for a loan of Rs. 20 lakhs SBI would charge a fixed interest rate of 8% in the 1st year and 8.50% in the next 2 years and from the 4th year onwards it will have a floating rate of 2.75% below SBI Advance Rate (currently 11.75%) effectively meaning that if SBI Advance rate remains where it is today the rate in the 4th year will be 9% (SBAR of 11.75% minus 2.75% = 9%). The EMI per lakh on this basis works out to Rs. 836 in the first year Rs. 867 in the next 2 years and Rs. 895 after 3 years.

If he went for the normal option of regular floating rate loans he will get an interest rate of 8.75% (EMI per lakh of Rs. 884) and will also be eligible for a similar loan amount of Rs. 20 lakhs.

If we run a simulation to see what happens if the interest rates rise by 2% in 2010, 1% in 2011 and another 1% in 2012 or a total of 4% in the next 3 years. As a result in the case of the SBI home loan the interest rates from the fourth year goes up to 13%. If he had gone for the floating rate loan the interest rate would be 10.75% (original rate of 8.75% plus 2%) in the first year, 11.75% in the second year and 12.75% for the period after that.

The Instalment to Income ratio in both cases go up sharply from 44% to 57% (indicating that a larger proportion of the income will go towards servicing the home loan) at the end of 3 years and in both cases are almost at the same levels. This means that irrespective of the type of loan the degree of difficulty in repayment would be similiar in both the loans if rates increase steeply by 4% over 3 years.

In both cases an 8% annual increase in income will ensure that the Instalment to Income ratio remains at the original levels. Of course in the regular floating rate loan the consumer ends up paying for the increase in interest rates in the first 3 years also. This increase will ensure that the instalment to Income ratio falls back to the mid forty levels that are considered safe by Indian standards.

How is loan eligibility calculated in a ‘teaser rate loan?

The loan eligibility is calculated taking into account the EMI after the teaser period is over. As per the above example the EMI per Lakh of loan in the 4th year would be Rs. 895. Typically the banks assume that 40% to 50% of the net income is available for repayment of home loan. Therefore from the income of Rs. 40,000 about Rs. 16,000 (40% of Rs. 40,000) to Rs. 20,000 (50% of Rs. 40,000) is available to be paid as an EMI. Based on an EMI repayment capacity of Rs. 16,000 to Rs. 20,000 and an EMI per lakh of Rs. 895 we can back calculate the loan eligibility amount at Rs. 18 lakhs to Rs. 22 lakhs or say around Rs. 20 lakhs.

So clearly whether the consumer chooses the ‘teaser rate product or the regular floating rate product he would face some difficulty if interest rates rise steeply as the IIR will increase to uncomfortable levels of 55%+. The IIR can fall back to reasonably comfortable levels if net income rises by 8% p.a. which should not be a big issue if our overall economic growth does not falter.

What would perhaps help, both banks and consumers, is if a transparent regime is put in place to ensure that increases in interest rates (and decreases for that matter) are worked out on a transparent and objective basis so that consumers are better prepared for such increases and the actual increase doesn’t come as a shock to them.